How to prepare for the day’s trading
Think of the many big decisions we make: buying a
car or house, taking an expensive vacation, selecting a college. In each case,
we exercise a degree of due diligence. We first investigate our purchase before
making a commitment. Why? We want to know what to expect. We want to know if
the car is reliable, if the house will truly meet our needs, if the vacation
will offer something for kids and adults, and if the college will be the right
academic and social experience. It may turn out that what we purchase does not
meet our expectations, but we’re more likely to recognize this quickly and make
adjustments if our expectations are clear to us.
So it is in the markets. If we know what to
expect in a market day, it provides us with a yardstick by which to measure the
trading session. If the market is meeting expectations, we can make trading
decisions accordingly. If the market is not behaving according to expectation,
that allows us to make quick adjustments.
In my research blog,
TraderFeed, and in my personal
homework before trading, I try to quantify market expectations. Writing this
article early Thursday morning prior to the open, for example, I see that the
S&P 500 Index is down over half a percent overnight after being down more than
1% from open to close the prior day. That leads me to ask the question: When
has this happened before, and what typically occurs afterward? I want to know
the expectations before committing my trading funds.
As it turns out, since 1996 (N = 2662 trading
days), we’ve only had 63 occasions in the S&P 500 Index (SPY) in which the
market was down more than 1% the previous day (open to close) and also down more
than a further half a percent by current day’s open. From the current open to
the *following* day’s close, SPY was up by an average .70% (37 up, 26 down).
That is considerably stronger than the average open to next day close gain of
.02% (1362 up, 1300 down) for the entire sample.
That suggests to me that there is no historical
edge in chasing the bear, near term. Indeed, there may even be an opportunity
to buy weakness and play for a short-covering rally. It is out of such
observations, combined with intraday setups and execution skills, that we can
build rationally grounded trading plans. (In actual practice, I look at
multiple historical patterns–not just one–in formulating trading plans).
One more observation, by the way. That down
market/down open pattern is much more common in bear markets (and volatile ones)
than during the recent low volatility bull. The appearance of this pattern
today–when we haven’t seen it at all during 2005 and 2006–may itself be
significant.
Brett N. Steenbarger, Ph.D. is
Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY
Upstate Medical University in Syracuse, NY and author of
The Psychology of Trading (Wiley, 2003). As Director of Trader
Development for Kingstree Trading, LLC in Chicago, he has mentored numerous
professional traders and coordinated a training program for traders. An active
trader of the stock indexes, Brett utilizes statistically-based pattern
recognition for intraday trading. Brett does not offer commercial services to
traders, but maintains an archive of articles and a trading blog at
www.brettsteenbarger.com and a
blog of market analytics at
www.traderfeed.blogspot.com. His book, Enhancing Trader Performance,
is due for publication this fall (Wiley).